A company’s financial statements constitute the core data used by business appraisers to value shareholder equity in statutory appraisal proceedings triggered by dissolution petitions brought by oppressed minority shareholders.
In my experience, most small and medium sized closely held businesses do not have audited financial statements but instead rely on their outside accountant to prepare either a compilation or review report which merely compiles management’s financial reports without any probing whatsoever (compilation) or employs a limited analysis of the company’s accounting practices and other factors but without any data testing as would be done in an audit (review).
When using the income and market approaches to value a business, appraisers engaged as expert trial witnesses routinely make “normalizing” adjustments to the income statement (a/k/a Profit & Loss statement or “P&L”) before applying a capitalization rate or market value ratios. For instance, the appraiser will eliminate extraordinary gains or losses, or may adjust officer/owner compensation to reflect reasonable compensation rates based on generally accepted industry surveys.
But beyond standard normalization, an expert appraiser using non-audited statements must determine whether the underlying income, expense, asset and liability data provided by management are reliable to a reasonable degree. Otherwise it’s GIGO — garbage in, garbage out.
That’s where forensic accounting comes in, as nicely illustrated in a recent case decided by Queens County Commercial Division Justice Orin R. Kitzes in Matter of Adelstein (Finest Food Distributing Co. N.Y., Inc., 2011 NY Slip Op 33256(U) (Sup Ct Queens County Nov. 3, 2011).
Adelstein involves a family-owned distributor of specialty foods called Finest Food. It was started by the Adelstein brothers Sidney, Jack and Joel over 50 years ago as a pickle distributor and later became the largest distributor of Caribbean foods in the New York metropolitan area. By 2006, Sidney and Jack passed their interests on to their respective sons who, in 2009, terminated their uncle Joel’s employment after he spurned their buy-out offer.
Joel initially sued his nephews for breach of contract and other claims which were dismissed in 2010. Shortly afterward he filed a petition for judicial dissolution of Finest under the oppressed minority shareholder statute, §1104-a of the Business Corporation Law (BCL). In August 2010, after Justice Kitzes denied the nephews’ motion to dismiss the petition on various grounds (read here my post on the decision), Finest elected to purchase Joel’s shares for fair value under BCL §1118. The court then held a valuation hearing featuring appraisal reports and testimony by the Company’s appraiser, Brian Serotta, a CPA with no appraisal certifications, and Joel’s appraiser, Paul Marquez, a CPA with an array of appraisal and financial forensic credentials.
The Company’s Appraisal
Serotta submitted a 3-page report based upon his review of the company tax returns, the “sparse records” he found and conversations with the company’s accountant and principals. He valued Finest using the capitalized income method only, with income adjustments to salaries, depreciation and loans to arrive at average normalized earnings of $206,000. Serotta computed a 20% capitalization rate (i.e., 5x earnings) that included specific company risk factors for limited management and its significant amount of business with the A&P supermarket chain which might end due to A&P’s bankruptcy. Serotta also purported to apply a 20% marketability discount to arrive at a $230,000 value for Joel’s one-third interest. I say purported because, as quoted in the decision, Serotta described what sounds suspiciously like a prohibited minority discount. Here’s what he said:
[The 20% marketability discount was used because of the] difficulty finding somebody to buy a one-third interest. There’s really no market. It’s a privately-held company. Anybody who bought that one-third interest would conceivably have nothing to say about the company.
Justice Kitzes’s decision describes in great detail the comparatively rigorous methodology used by appraiser Marquez whose $1,287,000 conclusion of value of Joel’s one-third interest is 560% higher than the Serotta valuation. In a nutshell, the disparity derived mainly from (1) Marquez’s determination of a weighted average net income of approximately $486,000 — more than double Serotta’s earnings base; (2) his application of a 12% capitalization rate (8.3x earnings) as compared to Serotta’s 20%; and (3) his application of a 5% marketability discount based on estimated transaction costs.
Marquez’s calculation of the company’s dramatically higher earnings base illustrates forensic accounting at work. Marquez discovered that while the company’s sales doubled in the years 2004 to 2010, from $5.1 million to $10.2 million, and its cost of goods sold grew commensurately, the gross profit margin oddly decreased in the last two years from 27.5% to 24%, at the same time the salaries of the two owner/officers went from zero to $500,000 annually. Critically, Marquez could find no reason for the gross profit margin to decrease when sales were significantly increasing, other than the existence of unreported sales.
Marquez tested his unreported-sales hypothesis by using a “stress test” to the sales invoices and other data. Here’s how Justice Kitzes describes the process:
He compared what was being received and invoiced for sales versus what was being reported as paid for those goods. According to this test, the company had a gross margin of profitability of almost 35%, rather than the 25% reported by the Company in its tax returns. Based upon this differential in profitability, given a company like Finest with gross sales of approximately $10,000,000, the amount of unrecorded sales was likely to be approximately $1,000,000 in 2010. He also based this conclusion on his analysis of the sales invoices, truck manifests and tax returns which showed that the gross profit experienced by the company was higher than that being reported. Consequently, he made a correction in the gross profitability of the company based upon the imputed existence of unreported sales. He then imputed gross profit for the company at the industry-wide level of 35% rather than the lower level of 25% reported by Finest.
Marquez’s forensic testing for unreported sales was bolstered by Joel’s testimony that some of Finest’s smaller chain store customers, as well as the many small bodegas it serviced, pay cash on delivery which is collected by the Finest truck drivers. According to Justice Kitzes’s summary of Joel’s testimony,
These cash sales are not computerized, but are contained in the salesmens’ reports. According to [Joel] Adelstein, about twenty percent of the entire business consists of smaller stores which pay cash in this manner.
Marquez next capitalized the $486,000 earnings base at a 12% rate, which he arrived at as follows:
|Risk Free Rate||4.43%|
|Equity Risk Premium||5.2%|
|Industry Risk Premium||(1.74%)|
|Small Stock Risk Premium||6.28%|
|Company Specific Risk Premium||0.5%|
|Long-Term Growth Rate||(2.7%)|
Applying the 12% cap rate to the $486,000 earnings base produced an enterprise value of $4,051,862, to which Marquez assigned a 70% weight. As a “cross-check” on his valuation he utilized the merged and acquired method weighted at 30%, looking at private market sales transactions that have occurred within the industry of companies falling within the same or similar Standard Industrial Classification (SIC) code. Marquez used Pratts Stats to determine valuation multiples of revenues, gross profit and EBITDA (earnings before interest, taxes, depreciation and amortization), which ultimately indicated enterprise values fairly close to his capitalized value, ranging from $3,990,000 to $4,094,000.
The weighted values produced a control, marketable value for Finest of $4,063,800 which Marquez then discounted 5% for lack of marketability reflecting the low end of his estimate for transaction costs in the sale of a small business like Finest. This generated a “fair value on a non-marketable value basis” of $3,860,610 which in turn generated a value of $1,287,000 for Joel’s one-third interest in Finest.
The Court’s Decision
Justice Kitzes’ decision highlights the crucial role of expert appraisals in a fair value proceeding, stating that “[i]n the case at bar, the valuation of Joel Adelstein’s interest in Finest rests primarily on the credibility of the appraisers and the reliability of their valuation methods.” Justice Kitzes further notes that “the extent of the witness’s qualifications has a bearing on the weight to be given to his testimony.”
Justice Kitzes concludes that appraiser Marquez’s testimony and report “are credible and reliable” based on his valuation and financial credentials; his “thorough process of evaluation of Finest” which included a site visit, understanding the business and industry, interviewing management, and carefully selecting valuation approaches; carefully selecting evaluation factors such as the capitalization rate; having a knowledge of New York law relevant to valuations; and taking into consideration Joel’s testimony concerning the “considerable cash business that would not be noted in the financial statements.” Justice Kitzes sums up on the last point:
He [Marquez] also explained the indications in the financial statements that such unreported sales existed. Significantly, [Joel’s] testimony regarding cash sales was not refuted by Respondents. In sum, the court finds that Marquez’ valuation report is clear, thorough, professional and reliable.
Justice Kitzes then contrasts the report and testimony of Finest’s appraiser who does not possess valuation credentials; prepared his 3-page report primarily relying on Finest’s accountant; did not take into consideration the existence of cash sales; devised a discount rate that relied on Joel’s minority interest in Finest; used a single method of valuation that was not checked against any other method; and in “an apparent contradiction,” stated that the gross sales of Finest had more than doubled between 2004 and 2010 but claimed that the profitability of the company had been “basically flat.” For these reasons, the decision goes on, “the court places diminished weight on the testimony and report of the Respondent’s expert concerning the valuation of Finest” and finds that the value of Joel’s interest in Finest is $1,287,000 — the exact value indicated by Joel’s expert.
Joel did not get everything he wanted, however. Justice Kitzes denies his request for an adjustment or surcharge against the other two owners in the sum of $863,000 for “salary, distributions and benefits” not shared with Joel. The requested adjustment, Justice Kitzes states, “functioned as a component of [Joel’s] calculation of the fair value of his shares,” presumably referring to normalization adjustments to the financial statements. In addition, Joel did not offer evidence that the salaries amounted to “willful or reckless dissipation” of company assets as required by the surcharge provision in BCL §1104-a(b)(2)(d).
Justice Kitzes also denied Joel’s requests for an award of attorney’s fees and for interest at 9% (the statutory rate) from the date of the filing of the dissolution petition. On the other hand, he denied the company’s request for a 5-year pay-out of the valuation award and ordered entry of judgment for the full amount, stating that “an extended payout period is not warranted in view of the time that this valuation proceeding has been pending and the time that the Respondents have had to allocate funds for payment.”
Adelstein is hardly the first valuation case in which the accounting for a company’s cash receipts became an issue. Business appraiser Mark Warshavsky, who also frequently lectures on forensic accounting, tells me that “whenever you have a company with cash sales, employing analytical procedures to benchmark account balances for the years included in your valuation as compared to other company years or industry data, is an excellent forensic technique.”
The forensic accounting done by Joel’s expert, tying in the company’s significant cash business to what was otherwise an anomaly in the financial statements, clearly resonated with the judge and, I can only speculate, cast a shadow on the company’s entire appraisal from which it never emerged. It is a lesson every appraiser and lawyer in a valuation case should not forget.
Update April 16, 2014: The nephews appealed from the decision discussed above. By decision this date, the Appellate Division, Second Department, unanimously affirmed Justice Kitzes’ valuation determination. Read here.